Our Insights

Quarterly Key Points

The COVID-19 pandemic is having a devastating impact on the global economy. Global markets have been roiled with equities down 20% - 30% YTD. Oil prices plummeted, falling all the way to $20 per barrel by the end of March on falling global demand and a price war between Saudi Arabia and Russia. Interest rates responded in-kind, collapsing to historic lows. Economists are now forecasting the most severe global economic downturn since the 1940s. Estimates of U.S. 2Q GDP range from -10% to -40% q/q annualized, while unemployment is expected to reach 12% - 15% almost immediately.

Governments across the world have enacted dramatic measures restricting travel, business and social activity, and education in a Hail Mary attempt to slow the spread of infection. At the end of March, Congress signed an approximately $2 trillion pandemic relief package designed to relieve cash flow stresses at the consumer and business levels. Only time will tell whether or not these measures will prove effective.

The Federal Reserve has responded in equally dramatic fashion, cutting rates to essentially 0%, establishing unlimited QE (and expanding it to include purchases of Agency CMBS), resurrecting lending facilities from its financial crisis playbook, and adding new programs. The implementation and success of these measures matters greatly in terms of supporting the economy until normal activity can resume.

Backward looking output numbers involving GDP, unemployment, manufacturing, and inflation will not be meaningful until updated data are released. That said, some more recently released economic numbers paint an ominous picture for unemployment and consumption. For example, initial jobless claims, a leading indicator and harbinger of unemployment, were 3.3 million and 6.6 million respectively for the last two weeks of March.

Our View

Although we entered 2020 with a certain degree of economic optimism resulting from the combination of the Phase I trade deal between the U.S. and China and an accommodative Fed, all of this will take a back seat to the pandemic.

We expect numbers regarding GDP and unemployment to reach startling levels in the coming months, as the impact of global stay-at-home orders sends shock waves through the economy. While many initially argued for a “V” shaped recovery, the reality now seems that any recovery will be “U” shaped at best.

However, the COVID-19 pandemic presents an unprecedented set of risks to the modern global economy and the markets. Much depends on the continued spread of the virus and the success of Government and health system efforts to slow the rate of infection. With so many unknowns, the wide range of economic outcomes being forecasted is indicative of a subdued level of confidence. For now, a wait and see approach is more prudent than ever. We advocate for investors to remain patient and maintain a heightened focus on downside risk.

1Q - A Global Pandemic and the Unknown

The COVID-19 pandemic has brought an unprecedented set of risks to the modern economy and is having a devastating impact. Global markets have been roiled by the rapid spread of the virus, with equities down approximately 20% to 30% year-to-date across the board. Oil prices plummeted, falling all the way to $20 per barrel by the end of March (down 66% year-to-date) on falling global demand and a price war between Saudi Arabia and Russia. Interest rates responded in-kind, collapsing to historic lows. The entire Treasury curve traded below 1% at one point, with 10-year and 30-year Treasury rates reaching unheard of lows of 0.31% and 0.70% respectively in early March (intraday lows) before ending the month at 0.67% and 1.32%.

A quick review of our year-end summary helps highlight how much things have changed over the course of just a few months. We entered 2020 with a certain degree of economic optimism. The Fed had concluded a series of three “mid-cycle adjustment” policy rate cuts and the expectation was for a quiet central bank during a presidential election year. Inflation remained in check, perhaps stubbornly low, triggering a policy debate about the efficacy of allowing inflation to run a little hot if needed. Labor markets had resumed full strength after a series of transient hiccups in the fall. Even the flagging manufacturing sector was showing signs of a turnaround in the wake of the Phase I trade deal between the U.S. and China. The economy seemed to be on a strong footing and GDP was set to gain momentum into the back half of the year.

Fast forward to the present, and all of this will take a back seat to the pandemic. As economic forecasters adjust their models, worst case projections seemingly get worse by the day. Clearly, a global pandemic is not an event many outside the epidemiology profession have given much thought. At this point, forecasting specific outcomes is extremely difficult as nobody knows how long the economy will be disrupted. Measures taken to slow the spread of the virus and the ultimate success of these measures will matter greatly. At present, the best case economic scenarios generally incorporate a return to something more normal in 3-6 months. However, expectations about the economy over the near-term are better measured against the depths of the 2007-2008 financial crisis and even the Great Depression. Indeed, economists are now forecasting the most severe global economic downturn since the 1940s. Estimates of U.S. 2Q GDP range from -10% to -40% q/q annualized, while unemployment is expected to reach 12% - 15% almost immediately.

Extraordinary Government and Central Bank Response

Thus far, policy response has been focused on three things: slowing the spread of the virus, providing financial support to consumers and businesses, and providing liquidity so that banking and capital markets can continue to function. Governments across the world have enacted dramatic measures restricting travel, business and social activity, and education in a Hail Mary attempt to slow the spread of infection. At the end of March, Congress signed an approximately $2 trillion pandemic relief package designed to relieve cash flow stresses at the consumer and business levels. (Putting that in perspective, that is ~10% of annual GDP, clearly unprecedented.) Additional measures initiated by agencies like the FHFA and the Department of Education include delayed payments on mortgages and student loans. These measures are all intended to ease payment stress for consumers. Similar plans are being implemented for multifamily property owners and tenants. The Federal Reserve has responded in equally dramatic fashion, cutting rates to essentially 0%, establishing unlimited QE (and expanding it to include purchases of Agency CMBS), resurrecting lending facilities from its financial crisis playbook such as the Term Asset-Backed Loan Facility (TALF), and adding new programs such as the Primary Market Corporate Credit Facility (PMCCF) and Secondary Market Corporate Credit Facility (SMCCF). The implementation and success of these measures matters greatly in terms of slowing the spread of the COVID-19 and supporting the economy until normal activity can resume.

The economic situation has changed very quickly; therefore, backward looking output numbers and data trends involving GDP, unemployment, manufacturing, and inflation are less meaningful. Nevertheless, some recently released economic numbers paint an ominous picture for the labor market. March non-farm payrolls dropped by 701,000, driving the three-month rolling average change into negative territory for the first time since 2010. Meanwhile, the unemployment rate increased to 4.4% from a 50-year low of 3.5% the month prior. Keeping in mind that this report reflects survey results through March 12, these numbers are worse than expected and suggest that labor markets were already deteriorating before wide scale shutdowns started in the U.S. Even more shocking, initial jobless claims for the last two weeks of March were 3.3 million and 6.6 million respectively. Assuming these claims transfer directly into unemployed status, the unemployment rate may already be around 10%. For perspective, the previous record for weekly initial jobless claims was ~700,000 in 1982 and unemployment reached 10% in 2009 during the financial crisis. Expectations are for an additional 15-20 million unemployment claims over the next month, driving unemployment to perhaps 15% or more.

On the consumer side, the most recent measures of income, personal consumption, and retail sales are all from February; however, we expect updated numbers for March to show early signs of stress consistent with rising unemployment. In the meantime, updated surveys of consumer sentiment may give us a glimpse into forthcoming data. The widely cited University of Michigan Consumer Sentiment Index fell to 89.1 in March from 101.0 in February, marking the largest month-over-month drop since October 2008. Data releases regarding the business sector are also signaling a sharp turnaround from the previous trend. For example, the Institute for Supply Management (ISM) Economy Weighted Index of manufacturing and services activity made an about-face, slipping from 56.5 in February to 52.1 in March. While not yet in contractionary territory, the direction of the change after consistent increases since late 2019 aligns with a rapidly slowing business sector. Further, the ISM Manufacturing Report on Business New Orders wasted no time diving deeper into contractionary territory with a reading of 42.2 in March following a reading of 49.8 in February.

Negative Interest Rate and Deflation Fears Resurface

As previously noted, interest rates collapsed in March. Furthermore, measures of interest rate volatility illustrate the rollercoaster ride that interest rate markets were on during the month. Aggressive Fed intervention and the $2 trillion Government stimulus package reshaped the curve with 10-year and 30-year rates retreating to 0.67% and 1.32% respectively by month-end. Interest rates this low naturally drive considerable debate about the possibility of negative interest rates and deflation. To date, the Federal Reserve has been adamantly opposed to the idea of negative policy rates. Indeed, there is mixed evidence of the stimulatory effects of negative interest rates on output and inflation in jurisdictions that have gone that route. Furthermore, according to the pundits, the Fed lacks the authority to charge banks for excess reserves (i.e. negative interest rates) and changing this would take an act of Congress. So, it seems unlikely that policy rates will be negative, but at this point we should never say never.

Also of concern, market measures of inflation expectations collapsed in March. The 5-year and 10-year breakeven inflation rates ended the quarter at 0.53% and 0.93% respectively after dipping to 0.17% and 0.55% mid-month. Short-term expectations are likely influenced by the sharp drop in oil prices, but we expect core inflation also will drop as a result of increased unemployment and decreased consumption. Longer-term expectations of ultra-low inflation are problematic for a levered economy, hence the Federal Reserve’s frustration with persistently undershooting its stated 2% inflation target. Whereas low inflation is a nuisance, deflation is the death knell that makes central bankers’ blood run cold as the uncontrolled devastation of deleveraging is soon to follow. For the last 40 years, interest rates have been on a one-way march lower as central banks have resorted to refinancing as the policy tool du jour. With interest rates suggesting neither real growth nor inflation are on the horizon, policy rates returning to the zero bound, and the Fed’s balance sheet already up to $5.8 trillion, central bank theory may be tested going forward.

Looking Ahead

The COVID-19 pandemic presents an unprecedented set of risks to the modern global economy and the markets. Much depends on the path of the virus and the success of Government and health system efforts to slow the rate of infection. With so many unknowns, the wide range of economic outcomes being forecasted is indicative of a subdued level of confidence. Currently, we expect numbers regarding GDP and unemployment to reach startling levels in the coming months, as the impact of a global demand shock reverberates through the economy. While many initially argued for a “V” shaped recovery, the reality now seems that any recovery will be “U” shaped at best. Current estimates suggest a peak in the pandemic could come later this spring; however, there is considerable variation around forecasts and the tail could be long. A strong economic recovery in the second half of the year is perhaps an optimistic expectation, as the unintended consequences of extended measures to stem the spread of the virus could limit our ability to return to “normal” economic activity. Additionally, the limits of central banks could be tested in the search for real growth and inflation. For now, a wait and see approach is more prudent than ever. We advocate for investors to remain patient and maintain a heightened focus on downside risk.

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